Why do nations trade?  The distribution of resources is uneven.  Efficient production requires different technologies or resource combinations.  Products are differentiated as to quality and other non-price attributes. ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO21

 Labour-intensive goods  Land-intensive goods  Capital-intensive goods ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO22

The Basic Principle  Specialization according to comparative advantage reduces costs  This is true even if a nation has an absolute advantage ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO23

Two isolated nations (Canada and Brazil) 1. Constant Costs  straight-line production possibilities curves 2. Different Costs  different technology & resources 3. Canada has absolute advantage in both steel and soybeans ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO24

Soybeans (Tonnes) Steel (Tonnes) Soybean s(Tonnes) Steel (Tonnes) (a) Canada (b) Brazil A Z LO Figure 16-3 Production Possibilities Curve ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO25

 Self-sufficiency output mix  Specialization and trade  Produce the good with the lowest domestic opportunity cost  Opportunity cost of 1 tonnes of steel:  1 tonnes of soybeans in Canada (1S t = 1S oy ).  2 tonnes of soybeans in Brazil (1S t = 2S oy ) ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO26

©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO27 Country (1) Outputs before specialization (2) Outputs after specialization (3) Amounts exported (–) and imported (+) (4) Outputs available after trade (5) Gains from specialization and trade(4) – (1) Canada18 steel30 steel–10 steel20 steel2 steel 12 soybeans0 soybeans+15 soybeans15 soybeans3 soybeans Brazil8 steel0 steel+10 steel10 steel2 steel 4 soybeans20 soybeans–15 soybeans5 soybeans1 soybeans Total output (steel and soybeans)4250 8

 What will the terms of trade be?  Canada 1S t = 1S oy  Canada will sell 1S t for more than 1S oy  Brazil 1S t = 2S oy  Brazil will pay less than 2S oy for 1S t  For trade to be mutually beneficial the terms of trade must be between each nation’s opportunity costs.  Settle between the two, depends on supply/demand factors (assume trade 1S t for 1.5S oy ). ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO28

 Gains from trade  Trading possibilities line  Slope equals terms of trade  Improved options  Complete specialization  More of both goods  More efficient resource allocation LO ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO29

Soybeans (Tonnes) Steel (Tonnes) Soybeans (Tonnes) Steel (Tonnes) (a) Canada (b) Brazil A Z A’ Z’ V V’ W v b b’ Trading Possibilities Line Trading Possibilities Line B LO Figure 16-4 Trading Possibilities Lines and the Gains from Trade ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO210

 Concave production curve  Resources not perfectly substitutable  Incomplete specialization LO ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO211

 Through free trade based on the principle of comparative advantage, the world economy can achieve a more efficient allocation of resources and a higher level of material well-being than without free trade.  Side benefits:  Promotion of competition, deterrence of monopoly  Linking of national interests, reduction of national animosities ©2013 McGraw-Hill Ryerson Ltd. Chapter 16, LO212